> The blowup occured because of the usual reason: if some is good, more
> is better. Until it's not. A number of factors came together to turn
> what was a rather ordinary and predictable shift of investment to a
> new class into an avalanche. None of them "caused" the boom; all
> contributed; many fed on each other. None can be ruled out. I think
> the effort to discard factors and search for The Ultimate Reason is
> doomed to fail.
If the causes of the housing bubble were so contingent and specific, why have there been so many other credit-fueled property bubbles throughout history? In the Panic of 1837 there were no CDOs, MBS, S&P/Moody's, zoning laws, etc, but the basic story was the same. That's why I'm dissatisfied with attempts to explain the bubble by pointing at contingent details like those, either singly or combined. They're just the Bush-era epiphenomenal manifestations of deeper underlying processes that have repeated themselves throughout the history of capitalism.
> On 8/29/2011 2:41 PM, Ted Winslow wrote:
>> It's not true that risk was "never really hidden."
>>
>> A very influential quant math model, David Li's "gaussian copula default function," widely used to determine the risk of correlated default on the mortgages underpinning mortgage backed CDOs, played a very significant role in their explosive growth. The formula extracted estimates of this risk from the pricing of their associated CDSs on the "assumption that financial markets in general, and CDS markets in particular, can price default risk correctly."
>>
>> "Using some relatively simple math—by Wall Street standards, anyway—Li came up with an ingenious way to model default correlation without even looking at historical default data. Instead, he used market data about the prices of instruments known as credit default swaps. ... When the price of a credit default swap goes up, that indicates that default risk has risen. Li's breakthrough was that instead of waiting to assemble enough historical data about actual defaults, which are rare in the real world, he used historical prices from the CDS market. ... Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly)."http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
This is actually a very good example of what I mean when I say that risk wasn't hidden, it was just assumed away by expectations of house price appreciation.
It might be true that some/many Wall Street mortgage analysts didn't understand the math behind this "Gaussian copula" whatsit. But they all understood the obvious fact that this formula couldn't hold up if it turned out that the housing market was experiencing a giant national bubble, since everyone knows that when a property bubble collapses default correlations rise to a level much higher than historical data will show. The important thing was the expectation of permanently high house prices; once people believe in that, it doesn't take much to convince them to put money in the mortgage market.
SA